What is managerial economics?
n Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources
n Managerial economics is (mostly) applied microeconomics (normative microeconomics)
Managerial economics deals with
“How decisions should be made by managers to achieve the firm’s goals - in particular, how to maximize profit.”
(Also government agencies and nonprofit institutions benefit from knowledge of economics, i.e. efficient recourse allocation is important for them too...)
Relationship between Managerial Economics and Related Disciplines
Management Decision Problems
Product Price and Output
Make or Buy
Production Technique
Stock Levels
Advertising Media and Intensity
Labor Hiring and Training
Investment and Financing
Decision Sciences
Tools and Techniques of Analysis
Numerical Analysis
Statistical Estimation
Forecasting
Game Theory
Optimization
Simulation
Economic Concepts
Framework for Decisions
Theory of Consumer Behaviour
Theory of the Firm
Theory of Market Structure and Pricing
Managerial Economics
Use of Economic Concepts and Decision Science Methodology to Solve Managerial Decision Problems
REVIEW OF SUPPLY AND DEMAND
Economic analysis begins and ends with demand and supply.”
The primary importance of demand and supply is the way they determine prices and quantities sold in the market.
Managers are extremely interested in forecasting future prices and output, both for the goods and services they sell and for the inputs they use.
DEMAND ELASTICITY
Elasticity measures the sensitivity of the quantity demanded to changes in the determinants of demand (supply).
Some elasticity concepts:
price elasticity of demand
elasticity of derived demand
cross-elasticity of demand
income elasticity of demand
elasticity of supply
Determinants of Price Elasticity of Demand
1. The number and availability of substitutes
2. The expenditure on the commodity in relation to the consumer’s budget
3. The durability of the product
4. The length of the time period under consideration
5. Consumer’s preferences
Short-Run vs. Long-Run Elasticity
A long-run demand curve will generally be more elastic than a short-run curve
As the time period lengthens consumers find way to adjust to the price change, via substitution or shifting consumption
Elasticity of Derived Demand
The demand for components of final products is called derived demand
The derived demand curve will be the more inelastic:
1.The more essential is the component in question.
2.The more inelastic is the demand for the final product.
3.The smaller is the fraction of total cost going to this component.
4.The more inelastic is the supply curve of cooperating factors.
5.The shorter the time period under consideration.
The Cross-Elasticity of Demand
Cross-price elasticity measures the relative responsiveness of the quantity purchased of some good when the price of another good changes, holding the price of the good and money income constant.
It is, therefore, the percentage change in quantity demanded in response to a given percentage change in the price of another good.
DEMAND ESTIMATION
In planning and in making policy decisions, managers must have some idea about the characteristics of the demand for their product(s) in order to attain the objectives of the firm or even to enable the firm to survive.
Demand information about customer sensitivity to
modifications in price
advertising
packaging
product innovations
economic conditions etc.
are needed for product-development strategy
For competitive strategy details about customer reactions to changes in competitor prices and the quality of competing products play a significant role
How would you try to find out customer behavior?
How can demand functions be estimated
Most common methods used are:
consumer interviews or surveys
to estimate the demand for new products
to test customers reactions to changes in the price or advertising
to test commitment for established products
b) market studies and experiments
to test new or improved products in controlled settings
c) regression analysis
uses historical data to estimate demand functions
Ask potential buyers how much of the commodity they would buy at different prices (or with alternative values for the non-price determinants of demand)
-face to face approach
-telephone interviews
Market Studies and Experiments
More expensive and difficult technique for estimating demand and demand elasticity is the controlled market study or experiment
Displaying the products in several different stores, generally in areas with different characteristics, over a period of time
for instance, changing the price, holding everything else constant
Experiments in laboratory or field
a compromise between market studies and surveys
volunteers are paid to stimulate buying conditions
A LINEAR REGRESSION MODEL
In practice the dependence of one variable on another might take any number of forms, but an assumption of linear dependency will often provide an adequate approximation to the true relationship
Think of a demand function of general form:
Qi = a + b1Y - b2 pi + b3ps - b4pc + b5Z + e
where
Qi = quantity demanded of good i
Y = income
pi = price of good i
ps = price of the substitute(s)
pc = price of the complement(s)
Z = other relevant determinant(s) of demand
e = error term
value of a and bi has to be estimated from historical data
SIMPLE LINEAR REGRESSION MODEL
In the simplest case, the dependent variable Y is assumed to have the following relationship with the independent variable X:
Y = a + bX + u
where
Y = dependent variable
X = independent variable
a = intercept
b = slope
u = random factor
Finding a line that ”best fits” the data
The line that best fits a collection of X,Y data points, is the line minimizing the sum of the squared distances from the points to the line as measured in the vertical direction
This line is known as a regression line, and the equation is called a regression equation
Estimated Regression Line:
Y= â + bX
THE THEORY OF PRODUCTION
Production theory forms the foundation for the theory of supply
Managerial decision making involves four types of production decisions:
1.Whether to produce or to shut down
2.How much output to produce
3.What input combination to use
4.What type of technology
Production involves transformation of inputs such as capital, equipment, labor, and land into output - goods and services
In this production process, the manager is concerned with efficiency in the use of the inputs
- technical vs. economical efficiency
Two Concepts of Efficiency
Economic efficiency:
occurs when the cost of producing a given output is as low as possible
Technological efficiency:
occurs when it is not possible to increase output without increasing inputs
PRODUCTION FUNCTION
A production function is a table or a mathematical equation showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology
Improvement of technology
f0(x) - f2(x)
Q = output
x = inputs
LAW OF DIMINISHING RETURNS
(Diminishing Marginal Product)
(Diminishing Marginal Product)
Holding all factors constant except one, the law of diminishing returns says that:
As additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish
e.g. trying to increase labor input without also increasing capital will bring diminishing returns
Nothing says when diminishing returns will start to take effect, only that it will happen at some point
All inputs added to the production process are exactly the same in individual productivity
OPTIMAL COMBINATION OF INPUTS
Now we are ready to answer the question stated earlier, namely, how to determine the optimal combination of inputs
As was said this optimal combination depends on the relative prices of inputs and on the degree to which they can be substituted for one another
This relationship can be stated as follows:
MPl/MPk = Pl/Pk
(or MPl/Pl= MPk/Pk)
OPTIMAL LEVELS OF INPUTS
The optimality conditions given in the previous slides ensure that a firm will be producing in the least costly way, regardless of the level of output
But how much output should the firm be producing?
Answer to this depends on the demand for the product (like in the one input case as well)
COST
The theory of cost is important to a manager because it provides the foundation for two important production decisions:
1-whether or not to shut down
2-how much to produce
“Buy low and sell high”
Increasing competitive pressures,
changing technology, and customer demand have made it harder for firms to achieve high profit margins by raising their prices
cost management, restructuring, downsizing etc.
outsourcing and relocation of manufacturing facilities to low-wage countries
mergers, consolidations, and then reduced
Which Costs Matter?
Opportunity vs. accounting cost
Opportunity cost is the cost associated with opportunities that are foregone by not putting resources in their highest valued use
Accounting cost considers only explicit cost, the out of pocket cost for such items as wages, salaries, materials, and property rentals
Sunk vs. incremental cost
A sunk cost is an expenditure that has been made and cannot be recovered--they should not influence a firm’s decisions
Costs in the Short Run
Total output is a function of variable inputs and fixed inputs
Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs)
Fixed costs
costs that do not vary with output levels
Variable costs
costs that do vary with output levels
TC = FC + VC
ECONOMIES OF SCALE
However, economies of scale occur when long-run average costs decline as output rises:
A cost related concept (Compare with returns to scale which is a production concept)
When a company is experiencing economies of scale its LRAC declines as output is increasing
Diseconomies of scale:
LRAC increasing as output
Economies of scale can be classified as
a) External economies of scale
advantages that a firm gains from the expansion and size of the industry as whole Þ industrial clusters
b) Internal economies of scale
advantages that a firm gains from increasing the scale of its own operation
ESTIMATION OF PRODUCTION AND COST FUNCTION
For practical decision-making purposes it is necessary to obtain estimates of production and cost functions.
In economics, it is usually hard to perform controlled laboratory experiments. Instead, actual operating data are used with some statistical procedures to derive these estimates.
Involves
1. Data collection (time series, cross-sectional data).
2. Have to assume some mathematical form for the function.
3. Have to determine the estimation method for finding the parameter values (regression analysis for instance).
THE COBB-DOUGLAS PRODUCTION FUNCTION
special case of power functions:
Q = aLbK1-b,
Original version with constant returns to scale ( b + 1 - b = 1) introduced by Cobb in 1928
He estimated the production function of U.S. manufacturing output for years 1899-1922
Properties
1.Both inputs have to be used simultaneously to get an output
2.Can exhibit different returns to scale (even though can not show a unit or an industry to move through all three stages)
3. Allows to investigate MP for any factor while holding all others constant. So it is useful both in short-run and long-run analysis.
4. Elasticities are equal to the exponents b and c. (constant in this formulation)
LINEAR PROGRAMMING
Linear programming is a mathematical technique that enables a decision maker to arrive at the optimal solution to problems involving the allocation of scarce resources.
Typically, many economic and technical problems involve maximization or minimization of a certain objective subject to some restrictions.
Programming problems, in general, are concerned with the use or allocation of scarce resources - labor, materials, machines, and capital - in the ”best” possible manner so that costs are minimized or profits maximized.
In using the term ”best possible” it is implied that some choice or set of alternative courses of actions is available for making the decision.
Typical Applications of Linear Programming
1. A manufacturer wants to develop a production schedule and inventory policy that will satisfy sales demand in future periods and same time minimize the total production and inventory cost.
2. A financial analyst must select an investment portfolio from a variety of stock and bond investment alternatives. He would like to establish the portfolio that maximizes the return on investment.
3. A marketing manager wants to determine how best to allocate a fixed advertising budget among alternative advertising media such as radio, TV, newspaper, and magazines. The goal is to maximize advertising effectiveness.
4. A company has warehouses in a number of locations throughout the country. For a set of customer demands for its products, the company would like to determine how much each warehouse should ship to each customer so that the total transportation costs are minimized.
The three basic steps in constructing a linear programming model:
Step I
Identify the unknown variables to be determined (decision variables), and represent them in terms of algebraic symbols.
Step II
Identify all the restrictions or constraints in the problem and express them as linear equations or inequalities which are linear functions of the unknown variables.
Step III
Identify the objective or criterion and represent it as a linear function of the decision variables, which is to be maximized or minimized.
Solving Linear Programming Problems
Graphical Technique
First graph the constraints:
the solution set of the system is that region (or set of ordered pairs), which satisfies ALL the constraints. This region is called the feasible set
Algebraic Technique
The graphical method solving linear programming problems can be used for problems with two variables (with some difficulty three)
However, for problems were the number of variables might run into hundreds or thousands, algebraic techniques must be used
The simplex method, with the aid of the computer, can solve these problems
SENSITIVITY ANALYSIS
Sensitivity analysis is the study of how changes in the coefficients of a linear program affect the optimal solution or
in the value of right hand sides of the problem affect the optimal solution
Using sensitivity analysis we can answer questions such as:
1.How will a change in a coefficient of the objective function affect the optimal solution? We can define a range of optimality for each objective function coefficient by changing the objective function coefficients, one at a time
MARKET STRUCTURE AND OUTPUT-PRICING DECISIONS
Firms output and pricing decisions depend on the current market structure in which the firm is operating i.e.
“How much control over price we have.”
whether the firm is competing in perfect competition, monopoly, monopolistic competition or oligopoly situation
MONOPLY
Why do monopolies exist?
Barriers to entry
-Control of scares resources or input
for instance diamonds (De Beers)
Economies of scale
-natural monopolies
Technological superiority
-but not a guarantee if network externalities exist
Government-created barriers
-Alko, patents, copyrights
PERFECT COMPETITION
Firms are price takers
they face a perfectly elastic demand curve
market price changes only if demand or supply changes
Given the market price, what is the appropriate level of production?
Since market price will settle at the point where only normal profits are earned Þ output will settle where
p = MC = AC = MR
Perfect Competition and Public Interest
The fact that p = mc leads to efficient resource allocation
Competition between firms will spur to efficiency
Will encourage the development of new technology
There is no point in advertising!?
in long-run equilibrium: LRAC at its minimum, so company producing at the least-cost output
Consumers gain from low prices
Quick response to changed consumer tastes
MONOPOLISTIC COMPETITION
Firms have some degree of market power
but demand curve typically flatter than in monopoly since there is more competition
Output-pricing decision is defined by
MR = MC as always
the absence of entry barriers means that super normal profits are competed away...
firms end up producing where p = AC, but AC not at its minimum as in perfect competition, also p > MC
Limitations of Monopolistic Competition Model
Information may be imperfect; firms will not enter an industry if they are unaware of the supernormal profits currently being made
Firms are likely to be different from each other not only in the product they produce or the service they offer, but also in their size and in their cost structure. Also the entry may not be completely unrestricted
The model concentrates on price-output decisions; in practice the profit-maximizing firm under monopolistic competition will also need to decide the exact variety of products to produce and how much to spend on advertising
OLIGOPOLY
A market dominated by a few large firms—imperfect competition
How concentrated is an industry?
consider the market share of four largest firms
Some highly concentrated industries (in the world or in a country):
mobile phones, paper industry, cigarettes, batteries, automobiles, banking, breweries, airplane industry, oil industry, etc.
The essence of an oligopolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors
Oligopoly may be characterized by collusion or by non-co-operation
Oligopoly and Public Interest
If oligopolists act collusively and jointly maximize industry profits, they will in effect be acting together like a monopoly and then the disadvantages to society would be the same as under monopoly
Further more, in two respects, oligopoly may be more disadvantageous than monopoly:
Oligopolists are likely to engage in much more extensive advertising than a monopolist
Depending on the size of individual oligopolists, there may be less scope for economies of scale to decrease the effects of market power
Threat of new entrants: This threat relates to the ease with which a new company or a company in different product area can enter a given trade sector. Typically, barriers to entry are capital, knowledge or skill. Conversely, advancements in technology have given rise to new ideas providing opportunity to new entrants.
Threat of substitution: This threat arises when a new product is available that provides the same function as existing product/service. For example, cotton fiber was, in the past, replaced by synthetic fiber, and glass bottles were substituted by plastic ones.
Bargaining power of buyers: The cost of producing and distributing a product should be less than the price it can bring in the market in order to be profitable. Number of competitors and the supply of a product are the two major factors that determine bargaining power of the buyers. A buyer is in a strong position to bargain for low price if there are many competitors and/or the supply of the product in the market is in surplus.
Bargaining power of suppliers: Businesses try to find more favorable terms from their own suppliers. If supply of raw material is plentiful and/or there are many suppliers, the supply can be procured at a low price. Otherwise, position is more favorable to the supplier having more bargaining power.
Competition between existing players: Competition among businesses is to get more buyers and trade at a price that produces an acceptable profit. If there are many players of the same size, capacity and strategy having little difference between their roduct/service, then there is fierce competition among them as regards the price of the product/service
E-ECONOMY: e-Products
and e-Marketplaces
and e-Marketplaces
E-commerce is already having a noticeable impact upon market structure and the behavior of business
E-Products
An e-product:
can be digitally encoded then transmitted rapidly, accurately and cheaply
e.g. music, films, books, sport …
Fixed costs of producing e-products are huge
but marginal costs of distribution are tiny
implying vast economies of scale
E-Marketplaces
B2C, C2B, C2C, and B2B
eMarketplaces differ widely in both their complexity and objectives
Their principal aim, however, is to bring buyers and sellers together:
-aggregation and matching
How might such marketplaces achieve these goals?
-improved computational and communication capability due to improved ICT
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